It will also create significant differences between staff depending upon which pension scheme they happen to be in. Some institutions will offer the Teachers’ Pension Scheme (TPS) instead of the USS, for example and the proposed changes to the USS will create a very uneven playing field between these two schemes.

The 3-yearly
actuarial valuation of the USS is currently underway, which will set the
contributions that employers need to pay into the scheme to fund future
benefits and also pay towards the deficit. More detail of how this works was
covered in our webinar from last year. Whilst this webinar was some time ago, it did
predict that the deficit, whilst large, would not be the biggest problem – instead
the main issue is cost of future benefits.

The cost of
providing pensions increased for two main reasons:

1) Increases in
life expectancy. If we retire at the same age and live longer, it costs more to
provide the same level of pension.

2) Lower expected
future investment returns. If you get a lower investment return in the future,
then to get the same out of a pension scheme, you have to put more in to make
up for the reduced return.

The trickiest part
is that we do not know for sure what will happen in the future – and remember,
when looking at pension schemes, we talk about what might happen to people who
are now in their 30s and 40s, when they are in their 90s (and beyond) – so we
really do have to look a long way forwards. Will people really keep living
longer over that timeframe? I don’t know, but I wouldn’t like to bet against
it. Will we really have lower investment returns in the future? It is
impossible to say for sure, but the limited information we have to go on at the
moment suggests that is the more likely outcome.

To compound this
issue, defined benefit (DB) pensions (like the majority of the benefits in the
USS) come with significant statutory guarantees. These mean that if you have a
challenging target, you have to provide it, even if things go against you, so
employers must plan for bad outcomes when considering the cost of such
pensions. It is very difficult to provide a lower guaranteed benefit, but
target a higher one (if things work out well) under the current regulatory
framework for DB benefits.

The first issue
is that pensions are costing more, which means you have to either pay more in
or get less out - and there is no way around that.

Meeting UUK’s
test of not diverting money from other core activities results in getting less
out, meaning some combination of:

- Having a lower
starting pension

- Retiring later
(so your pension is paid for a shorter period)

- Not receiving as
high annual increases to your pension (so you get the same amount at outset,
but relatively less later in retirement)

That last option
– reduced pension increases - is worth looking at in more detail because:

- The increases
are very expensive making up around one-third of the cost, giving significant
scope for saving, without affecting the headline pension amounts staff receive.

- Generally,
staff do not understand how costly increases are. The value they place on the
increases may not equate with the cost of providing them - does everyone need
the same purchasing power in their 80s and 90s as they had in their 60s and
70s?

From an employer value for money point of view, the
increases are therefore not very cost effective. Removing the increases would
create a more affordable and better targeted use of resources. Therefore to
reduce cost, I think the first place to look is the increases – the big problem
here is that it is a statutory requirement for DB schemes to provide pension
increases (albeit not quite to the level that the USS does).

To compound the
issue, pension increases cost even more when people are living longer and
investment returns are lower (because these are both about increased cost to
pensions further away – where the increases have the biggest impact).

There are
basically three ways that increases could be removed, if that were the desired
solution:

1) Move to DC (as
proposed). The flexibility to shape income to suit needs in retirement is one
of the key benefits of DC relative to DB.

2) Government
intervention to remove the statutory increase requirement

3) Move to a
“cash balance” type of pension scheme

It is hard to see
the Government changing legislation given the needs of just one pension scheme,
so, other than the proposed move to DC, that just leaves the cash-balance
option.

A cash balance
scheme is like a DB scheme until the member retires and provides a pot of money
at retirement based on a formula (how long you have worked, and what your
salary has been, like in a DB scheme). However, the pension that is provided is
more like that from a DC scheme – the employee uses that pot of money to
purchase a pension in the form they would like and all the standard DC
flexibilities would apply.

In the absence
of a change to legislation, a cash balance arrangement would offer a more
affordable way to target contributions to employees’ needs, whilst still giving
some guarantees around the level of benefit they would receive.

Fundamentally,
any scheme which offers some guarantees over the level of benefits will have
uncertain costs. Cash balance schemes do provide guarantees, so that
uncertainty would remain, albeit at a much lower level than with the current
USS benefits. Universities are unsurprisingly keen to have stable costs and an
attempt was made at the last actuarial valuation to look at how to minimise the
risk of increasing contributions above 18% in the future. The problem with
that, of course, is that however small the risk of higher costs, it can still
happen (as we have seen!).

The only way to
have certainty around the cost is to move to a DC scheme as proposed. You then
get complete certainty for the employers over the cost of future benefits (but
not deficit contributions). The risk instead falls on members who will get
lower pensions at times when pensions cost more, as the employer will no longer
be topping them up if needed. A middle ground of cash balance could
significantly reduce the volatility, but would not eliminate it altogether.

The deficit has become
bigger over the 3 years to the valuation date (exactly how much depends upon
how you measure it) and this trend could continue, having said that - it could
also reverse. One thing for the employers to beware of is, if the USS moves
fully to a DC basis, then the USS trustees are likely to focus even more on
protecting the past DB benefits. This could lead to a more prudent approach
being taken and/or shorter recovery periods at future valuations – leading
again to an increased demand for contributions towards the deficit in the
future.

Led by Paul Hamilton, Partner and Head of Higher Education, our HE team have built a reputation for our ability to identify key challenges and help our clients respond to these promptly. If you would to find out how Paul and his team can help you, visit our Higher Education page here.